Three 401(k) withdrawal rules that will help your retirement savings last
How to plan your 401(k) withdrawals to ensure your money lasts as long as possible
Saving for retirement is tough, and once you reach retirement age you may think the hard part is over. However, you have one more challenge -- making sure your savings last as long as possible.
Regardless of how much you have saved for retirement, it won't matter unless you manage your spending appropriately. If you withdraw too much too soon from your retirement account, your savings may only last a few years.
While everyone's withdrawal plan will be slightly different, there are a few rules to keep in mind as you're determining how much you can safely withdraw from your 401(k) during retirement.
1. Be flexible
One of the most common withdrawal guidelines is the 4% rule, which states that you can withdraw 4% of your total savings during the first year of retirement, then adjust your withdrawals each year after to adjust for inflation. While that's a good benchmark, it doesn't account for the fact that many retirees see their expenses fluctuate from year to year.
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56% of U.S. households experience spending volatility in retirement, according to a report from JPMorgan Chase. You may also experience waves of higher or lower spending levels. For example, you could spend more than usual during your first few years of retirement if you plan to travel extensively or pick up expensive new hobbies, then your spending could taper off as you settle into your retirement lifestyle. Your expenses could creep up again, though, as you get older and potentially develop costly health problems.
Although you may not be able to predict exactly how much you'll spend each year in retirement, try to be flexible with your withdrawal plans. If you expect to stick to a rigid spending plan, it could throw off your retirement if you end up spending more than expected.
2. Don't ignore required minimum distributions
Once you turn 72 years old, you'll need to start taking required minimum distributions (RMDs) from your 401(k). Exactly how much you'll need to withdraw depends largely on your 401(k) balance, and it's calculated by the IRS.
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If you don't take your RMD on time, you'll be hit with a hefty tax penalty -- 50% of the amount you were supposed to withdraw. So if you have RMDs of, say, $20,000 per year and you skip a year, you'll face a penalty of $10,000.
RMDs can potentially throw a wrench in your strategy if you plan to continue working into your 70s. In general, you're still required to take RMDs even if you're still working at age 72. However, you may qualify for an exception if you have a 401(k) through your current employer. If you also have a traditional IRA or old 401(k) accounts from previous employers, though, you'll still need to take RMDs from those accounts.
3. Factor taxes into your withdrawals
Your 401(k) is a tax-deferred account, meaning you won't pay taxes when you make the initial contributions, but you will owe income taxes when you start taking withdrawals. So if you're not accounting for taxes as you're planning your withdrawals, you might be in for a surprise.
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How much you'll owe in taxes depends on where you live as well as how much you plan to withdraw. If you withdraw roughly the same amount that you're earning now, your taxes might not be drastically different. But if you move to a new state or spend far more or less in retirement than you do now, your tax situation could change significantly.
Before you retire, consider how taxes will affect your withdrawals. If you're planning on moving to a new state, determine whether that state taxes retirement income. Depending on where you live, you might be able to get out of paying income taxes altogether. Otherwise, consider how your spending may change in retirement and think about how that will affect your tax bracket. By budgeting for taxes now, you can adjust your 401(k) withdrawals accordingly.
Planning your 401(k) withdrawals is a crucial step in the retirement preparation process because it will ensure your money lasts as long as possible. And by following these rules, you'll be on your way to achieving your retirement goals.